National Blog

Central Planning and Economic Calculation

The problems of central planning and government services run much deeper than a simple question of inefficiency. The fundamental flaw of government spending is in the impossibility of economic calculation. Ludwig Von Mises noted this vexing quandary, which arises when goods and services are purchased through taxation. In the absence of consumer prices, there is no possible way to determine whether or not government expenditure is cost effective or is meeting consumer needs. This impossibility becomes even more pronounced in societies with no free market at all (such as the former Soviet Union). Allow me to explain.

In the free market, all goods compete against all other goods (not just apples and apples). For example, you may choose to buy cheaper shoes so you can afford a nicer house, or you may eat cheaper food in favor of a better car. In making constant decisions about which things are more important to you than others, you make decisions about which businesses get the most capital. You determine how much you are willing to spend for each item. The whole mass of consumers, making such decisions every day, sets the price levels for all goods and services and this determines how labor and resources are allocated in society.

Many people mistakenly believe that consumer prices are set by the cost of raw materials and other factors of production. This understanding is actually backwards. The final price of consumer goods indirectly sets the price for labor and factors of production. For example, if there were no consumer goods which required copper, there would be no value in mining for copper. It would be worthless and nobody would work to obtain it. Because there are numerous goods which use copper, all of the producers of these consumer goods compete to bid on copper. This market competition determines the prices for mining and processing of this metal. If demand goes up, copper mining will become more lucrative. This, in turn, will drive more people into the industry, ensuring that there is enough production to meet the increased needs. In essence, the price for copper is determined by demand for all of the end consumer products which use copper.

If a new product requires copper in its production and there is great demand for this item, this will increase the price of copper. That will raise costs for producers of all items in which copper is a factor of production. If consumers are unwilling to pay more for an existing product which uses copper, this may make it unprofitable to continue to make that product. The entrepreneur who makes the old product will need to change his business plan, or go bankrupt. This is unfortunate for him, but it is best for society. There are limited factors of production available and there must be a mechanism to determine how much capital (labor, factories, machines, and raw materials) goes to the production of different goods. The subjective valuations of consumers make this determination through market prices. If people are willing to pay enough to make the new product profitable, but not the old, it means that they value the new product more than the old (otherwise they would buy the old product instead). Without these important market signals, too many resources could be dedicated to something people do not desire, leaving too few resources available for the production of something which people would prefer.

Now let's look at how this works with government spending. I will use an example of a mixed economy, such as that in the United States (a blend of socialist/corporatism and capitalism). When government spends to provide a good or service, there is no price determined by the voluntary purchases of consumers. Instead, the money is involuntarily confiscated through taxation. How does this impact economic calculation? Let's imagine that the government decides to give away Segway® personal transports to everyone (a government Segway® giveaway would not necessarily have the expansive consequences that I will describe, but it will serve to illustrate the principle). Right now, most of us do not have Segways®, because we feel that other things would be of greater value to us. Thus, we direct our capital to these other things. When the government, however, is handing out Segways® for "free," of course, everyone will line up to get one. This will create higher demand for the factors of production that go into making a Segway®. This will increase production costs for all other goods that use the same factors of production (perhaps various electrical appliances). This means that the cost of these items will go up. Some people, who may otherwise have wanted them, will have to forgo these items in favor of meeting more urgent needs. In the meantime, the government will have no way of knowing that the people would have preferred these other goods. They will assume that, because everyone seems to want a Segway®, this is a very popular program. The consumers won't recognize the relationship either. On the market, they would have stopped purchasing Segways® long ago, but they will continue to vote for the politicians who "give" them the Segways® and vote against those who oppose the program. Because people are paying more taxes to fund Segway® production and they must pay higher prices for electrical appliances, they have less money to spend on houses, food, and whatever other items they might have otherwise considered more valuable. They can see the Segways® that they receive, but there is no way to know what goods they have had to sacrifice in exchange.

The more wealth the government spends, the less capital is allocated to meeting the needs of the people (as determined by the peoples' own valuations). Instead capital is allocated to meet the whims of bureaucrats and politicians. Because people perceive these things as "free" goods and services, they unwittingly participate in their own impoverishment by supporting the programs. The politicians begin to see support for such programs as an easy way to buy votes (with the peoples' own money). The whole thing becomes self-perpetuating.

It is impossible for any central planners (no matter how brilliant) to determine how to distribute capital and labor as the free market would. This is what caused so many problems with shortages and rationing in the former Soviet Union. The government constantly misallocated factors of production and misjudged the needs of the people. This led to a squandering of capital and wasteful spending. The Soviets tried to solve their problem by spying on the US and other markets to determine price and attempt to recreate a simulated market, but this was a futile effort. The folly of the Soviet central planners eventually led to complete financial collapse.

Segway is a registered trademark of Segway Inc. in the United States and/or other countries.